The fall in commodity prices and China’s slowdown are at the roots of global financial uncertainty and the reversal of capital flows towards developed markets. In a comprehensive interview about Italian banking in a global context, the Governor of the Bank of Italy, Ignazio Visco, analyzes the shift in global investment trends, the impact of the European “bail-in” regulation on financial stability, and the consequences of deflationary pressure on growth prospects.
Diverging monetary policies are creating an uncertain effect on the global market. Emerging markets are showing their vulnerabilities after the announcement of the Fed about increasing interest rate. After the rush of the past 10 years to emerging markets, are developed economies back at the core of global investment trends?
This is an important question. The first observation I’ll make is that there is some overstatement about the impact of monetary policies, and the Fed’s monetary policy on emerging market economies in particular. Certainly, there was an effect in 2014. But recent moves have been largely anticipated, and even the future moves are going to be gradual and I suppose communicated in a way that their impact will not be disorderly.
We are in a period of uncertainty. On one side, the stress in emerging economies is immediately visible with the fall in commodity prices, since many of these economies are exporters of oil and other commodities.
Secondly, there is clearly a substantial slowdown in China, which is having a global impact, but is directly affecting emerging economies because important parts of the global supply chains are there today. The Chinese slowdown also means slower growth prospects in advanced economies.
These two effects together are at the root of the global uncertainty. We are seeing that there is a reversal in capital flows to emerging market economies. This is very important because much of investment that was taking place in the last, say, 10 years is somehow being reversed.
This is a point where one should then raise a fundamental question. Is this reversal going to be permanent or not? That is a very difficult question to answer, but one thing that we should have in mind is that the potential growth of the emerging world is still very high. In particular, there is still lot of room for further investment in infrastructure.
In this climate of uncertainty that has become more and more evident since the beginning of 2016, what do you think has been the impact of the new European regulations on the resolution of banking crises (Bank Recovery and Resolution Directive, BRRD) on the stability of the financial system?
I think its effect has been exaggerated. The BRRD has had an impact, but the turmoil that we have seen in financial markets and some downward trend is mostly associated with the changing growth prospects or expectations about the economic outlook.
If growth prospects go down and in the meantime the regulatory framework for the financial sector becomes stricter, the two factors combined imply that banks’ profitability may be reduced. As a consequence, the stream of future dividends will be less than expected, and this is reflecting in the stock prices.
The BRRD, or “bail in”, has had an impact, but more on the liquidity risk rather than on share prices. The turbulence you are seeing is mostly in the stock market.
The “bail in” may create difficulties in terms of higher cost of funding, and therefore higher cost of credit to the economy; credit may also become more difficult to obtain and banks may experience a decrease in profitability.
There has been great speculation lately about the solidity of the Italian banking system. Do you think it is solid enough to overcome this period of turmoil?
The turmoil that we have seen in banks’ stock prices is not only limited to Italy. It has extended to other systems in Europe, not only in Greece, Portugal, or Spain, but also Germany and France. The reason is always the quality of assets. Ever since the global financial crisis of 2007-2008 there have been complex and opaque financial instruments circulating in the financial systems, and there are legacies of these assets in the large banks around the world, which have implied a response of regulators to preserve financial stability.
There are also cases in which stability has nothing to do with these financial products, but rather with the performance of economies. Italy had a double-dip recession in the last eight years, and this recession led to a fall in GDP close to 10%. Industrial production has fallen by 25% and consequently non-performing loans (NPLs) have increased. This increase in NPLs is perceived as a problem in terms of banks’ assets quality.
In the last four, five years, we have acted very strongly to have banks increasing their provisions, and since November 2014 our efforts have also been joined by the ECB in its new capacity as European banking supervisor, with a direct responsibility for the largest banks.
What needs to be understood—and this is not considered by many commentators—is that Italian banks’ bad debt is guaranteed to a large extent by collateral, which is mostly real estate. And in contrast to other countries, real estate prices in Italy are not overstated.
The issue is that it takes a long time to recover the collateral, and this is reflected on the banks’ capability to get rid of bad loans. This aspect should be improved through the judicial reform.
Our simulations suggest that if Italy had the same procedures that are in place in France and Germany, most likely the stock of NPLs would be half of what it is.
The government has introduced in the summer of last year new bankruptcy and foreclosure proceedings which expedite the recovery, and I think more will be done.
Moreover, the Ministry of Economy and Finance has recently reached an agreement with the European Commission on a government guarantee scheme for senior tranches of securitized bad loans that will facilitate the creation of a secondary market for non-performing loans.
Overall, there is an exaggeration in the way the markets are pricing the stocks of Italian banks. There is a perception of asset quality that is excessively penalizing—and you must also remember that only two years ago, we ran a very severe, comprehensive assessment of all banks.
Overall, the big problem is profitability again because the banks generate enough returns, but a good part of that is used to cover the expected losses on NPLs.
What measures can banks undertake in order to help prevent crises and increase trust in the financial system?
Certainly, banks still need to undergo a number of changes in their business model, in terms of cost cutting, while taking more advantage of the technology available. Innovation is fundamental, as is building better customer relations. Indeed, there is an issue of financial education, which mainly has to do with how investors understand the risk they incur when they put their savings in particular financial instruments.
Also, it has to do with the behavior of banks when they illustrate to their customers the risks attached during the sale of such instruments.
From the reaction at the European level on the government’s request for flexibility, it seems like there’s a general perception about Italy using or trying to use government funds in order to rescue the banking system. Is that true?
No, Italy is the country that hasn’t used government funds in order to save banks. It is very well known. Most of European countries as well as the US have used a lot of support from government after the global financial crisis, after Lehman Brothers. Italy has used the minimum of support, and this has completely been repaid with high interest. As a matter of fact, if you look at the statistics of the ECB, you’ll see that Italy is the only country that after the crisis had made some profit, not a loss. On the contrary, large sums of money were put in banks in Germany, Netherlands, Spain, United Kingdom, and US.
After this substantial support of the banking industry, a decision was taken in Europe to avoid bailing out banks in the future. What was allowed in these countries became no longer possible. Italy has not been in a position to bail out according to these rules.
The question is whether there are possible state aids that could be justified by particular conditions. More thinking on that is needed.
The reasons why these “bail-in” reforms have been introduced are basically twofold. One is financial stability and the other is moral hazard: opportunistic behavior on the part of banks that leads them to take excessive risk on the assumption of being bailed out with public funds once things get out of control.
These motivations are reasonable; the problem is that at the European level insufficient attention was given to the transition period. A gradual transition and a targeted approach—with the application of the bail-in to only financial instruments with specific contractual clauses—would have been preferable and more in keeping with that adopted by the Financial Stability Board.
Austerity policies implemented at European level have exacerbated the crisis. What are your expectations in terms of the inflation rate in Italy for 2016? Is the deflationary pressure finally over?
As I have already recalled, Italy has had a double-dip recession. This recession has ended last year. In 2015 the growth rate of activity was 0.8%.
The fact that domestic demand is still pretty modest has an impact on inflation, which adds to the impact that comes from commodity prices. The main risk is that the persistently low dynamics of consumer prices has an impact on inflation expectations in the medium-to-long term, which in turn would affect actual wages and prices. This is the so-called ‘second-round effect’.
I’m worried about that. Worried that there is a risk that this has a deflationary impact. We have projections for this current year of very limited price changes, in the decimals.
The ECB staff is revising its macroeconomic projections, which will be available in March when we will take another decision on monetary policy (the interview took place before the meeting of the Governing Council of March 10).
We have a target of close to 2% inflation rate, which represents price stability. We can have blips below and above the 2%, but if you are persistently below and very close to 0%, it is likely that expectations will disanchor from our target. Once this happens, it is very difficult to induce a change, as we have seen from the Japanese experience. This is why long lasting low rates of inflation are worrisome.
You have dedicated your professional career to the Bank of Italy and the OECD as well. What are the key lessons you have learned throughout your professional career?
There are a number of things. First of all, I think it’s very important to understand that no matter how accurate, profound, or deep your analysis is, there will be a substantial lag before that can enter a political debate.
For instance, one obvious issue is the aging population. Demographics look very complicated 20 years from now. The next 20 years are already decided. To adjust the world to that is the responsibility of politicians.
On the other hand, they have to be elected. This is a substantial tradeoff between whether you will be able to maintain your job or not, and at the same time introduce the reforms that are needed.
We live in a world of electoral cycles. There are elections not only every four years, but every other month. In a union like the one we are in, this means that every two months, there is an election: it may be either in Spain or in Italian cities or in German länder or a referendum in England.
Now this implies that the ability of politicians to sell a long-term project is really a function of their ability to lead people. Leaders are unfortunately much more under the pressure of delivering very fast something that they can promise rather than educating on what would be good for society at large. Then there might be different views on that, but the debate is not on that. The debate is on what can we obtain tomorrow.
The other issue concerns directly monetary policies because when things go bad, you always end up asking central banks to do something. But central banks don’t do miracles.
For example, we need to increase the rate of growth of our economies in a strong, sustained and balanced way, which is how this goal is set by the G20. Just strong, sustained and balanced. Monetary policies have nothing to do with that. Monetary policy can provide stable conditions, but unless you improve the business climate, unless you have infrastructures that work and skilled human capital, nothing will change.
Structural reforms need to tackle the efficiency of the public administration, flexibility of the labor market, competition among firms, and measures to curb corruption and criminal activities